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Long-Term Capital Gains: You Want These for More Than Their Lower Tax Rate

There's a simple and obvious reason you should favor long-term capital gains over short-term ones: You'll face a lower tax rate. But dig a little deeper into the issue and you'll find an even better reason to aim for long-term capital gains -- that is, long-term investing is an excellent way to build great wealth.

Tax talkLet's start with the capital gains tax rate, though. For most people, the tax rate on long-term capital gains (for assets held for more than a year) is quite low. In fact, for those in the 10% or 15% tax brackets, it's 0%. Most investors, though, face a 15% capital gains tax rate, while those in the top bracket pay 20% and those earning more than $200,000 for single filers and more than $250,000 for joint filers get slapped with ad additional 3.8% surtax.

For short-term gains (those generated from assets held for a year or less), the capital gains tax rate is your ordinary tax rate, which could be in the 33% to 40% range if you're a high earner. (For most of us, it will be 25% or maybe 28%.)

Thus, there's an immediate incentive to aim to hold on to any holding for at least a year and a day, as long as it makes sense to do so. Very often, though, we'd do well to hang on for at least a year and many more years.

Long-term resultsThat's because when you've invested in a healthy, growing company, if you've chosen well, it's likely to keep growing at a good clip for many years, not just the next one or two. Sure, it may be overvalued at times -- but you often won't realize that except in hindsight -- and it may drop or stall for some years. But over many years, it's likely to do quite well.

Check out these examples:

Stock

2-Year Average Annual Return

10-Year Average Annual Return

20-Year Average Annual Return

What $10,000 Would Become Over 20 Years

S&P 500

14.6%

5.5%

7.4%

$41,695

Boeing Co.(NYSE: BA)

38.5%

12.7%

11.9%

$94,755

Johnson & Johnson(NYSE: JNJ)

15.9%

7.1%

12.5%

$105,451

Microsoft Corporation(NASDAQ: MSFT)

26.3%

7.6%

14%

$137,435

Home Depot Inc.(NYSE: HD)

28.6%

13.9%

14.7%

$155,335

CVS Health Corp.(NYSE: CVS)

41%

15.6%

15.6%

$181,617

Sherwin-Williams Co.(NYSE: SHW)

30.9%

22.2%

17.2%

$239,085

Altria Group Inc.(NYSE: MO)

30.9%

19.6%

18.6%

$303,175

Starbucks Corporation (NASDAQ: SBUX)

27.2%

14%

23%

$628,206

Long-term gains can be quite large if you're investing in healthy, growing companies.

These numbers illustrate many points. For example, you don't have to be a young high-tech company to deliver strong results over a long period. Starbucks has gotten where it is mostly via coffee, while Altria has mainly been selling tobacco, and Sherwin-Williams is all about paint. All of them outpaced Microsoft, which itself nearly doubled the overall market's return over the past 20 years.

It's true that you won't zero in on the next two decades' best performers -- no one can know which companies those will be. But the beauty of investing in a handful of healthy and growing stocks for the long run is that many will still do quite well. They will likely outperform the market and often will more than make up for any underperformers. (You can also shed underperformers along the way, if you lose confidence in their futures.)

Many of us would do quite well to just invest in index funds for the long run.

Heck, even if you just invest in the S&P 500 -- which is a perfectly reasonable and exceedingly easy thing to do -- you'll likely do quite well. Over many decades, the overall market has averaged annual gains of close to 10%. The market undershot that over the past 20 years, but you would have still quadrupled your money in it. Had it averaged 10%, your $10,000 would have grown to $67,275. The S&P 500 has outperformed the majority of managed stock mutual funds over most long periods, too -- investing in it is far from settling.

Studies show ...

Don't just take my word for it, though, when it comes to the value of long-term investing. Consider the words of superinvestor Warren Buffett, who has said that his favorite holding period is "forever."

Aiming for long-term gains and, therefore, long-term capital gains tax rates, is a win-win proposition. It's even easy, to boot. Researchers have shown that frequent trading hurts results, in part because of commission costs and short-term taxes -- but also because of overconfidence, and to investors succumbing to emotions. If they're not committed to staying the course through downturns, they're likely to panic during a market crash and sell at a suboptimal time.

Longtime Fool specialistSelena Maranjian, whom you can follow on Twitter, owns shares of Johnson & Johnson, Microsoft, and Starbucks. The Motley Fool recommends CVS Health, Home Depot, Johnson & Johnson, Sherwin-Williams, and Starbucks. The Motley Fool owns shares of Johnson & Johnson and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Author

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter... Follow @SelenaMaranjian